US chemical stocks have embarked on a robust rally from their
September lows, catalyzed by a steep decline in energy prices and
the anticipation of a strong economic recovery in mid-2002. While
the rising tide has lifted all boats in the commodity, diversified
and specialty chemicals sectors, many on Wall Street question
whether this latest resurgence has legs, as fundamentals have yet
to catch up to stock prices.

"We're seeing some pretty indiscriminate buying in the chemicals
sector," says JPMorgan major chemicals analyst Donald Carson.
"Generally, a lot of money managers have missed the run-up in
cyclical stocks, and so what you're seeing is some people jumping
in to take advantage of this year-end rally."

Merrill Lynch analyst John Roberts attributes part of the surge
to a rebound from tax-loss selling of depressed chemical stocks. "A
lot of institutional investors close out their accounts late in
October, and once that seasonal selling pressure is off, you would
expect a bounce off that," he says. In addition, "you may have had
a Dow Chemical halo effect over the past few weeks since they
expressed optimism about an economic recovery in late 2002 and a
cyclical peak coming some time in 2004 at their annual investor
meeting."

"This rally is being driven by lower energy prices as well as
the expectation of a rebound in industrial production at some point
next year," says ABN Amro specialty chemicals analyst David
Begleiter. "We've had the worst industrial downturn since the Great
Depression and at some point things will reverse. So you need to
own these stocks prior to the recovery."

With crude oil recently falling to around $17 per barrel, its
lowest level since mid-1999, chemical companies stand to benefit
from significantly lower raw material costs. However, the demand
side of the equation remains murky with little evidence that things
are picking up.

"There's no doubt lower raw material costs will be helpful, but
I don't think it will be enough to really change the game here,"
Mr. Begleiter notes. "Evidence of any pickup in demand is spotty.
On the industrial side, things are still limping along."

The direct beneficiaries of lower energy costs are the commodity
chemical companies. Lyondell Chemical Company has enjoyed a
blistering 66 percent rise in its stock price since September 21,
from a low of $9.45 to around $15.73 (see chart). Other major
chemical companies registering sizeable gains include DuPont
(+37%), Eastman (+36%), Millennium (+35%) and Dow Chemical
(+29%).

"The rally in Lyondell does not appear to be grounded in
fundamentals because we know in this case that the fundamentals in
ethylene do not look too good," says Argus Research's Mr. Kerans.
"While they will benefit from lower oil prices, that doesn't
warrant a 50 percent plus move in its stock price."

Specialty chemical companies are also poised to benefit from
falling raw material costs. Valspar Corp. in particular could be a
good play on falling crude oil prices, a US economic recovery and
lower interest rates.

"With around 75 percent of cost-of-goods-sold comprised of raw
material costs, particularly heavily weighted towards
petrochemicals, Valspar tends to be a major beneficiary of lower
oil prices," says Lehman Brothers analyst Timothy Gerdeman. "In
addition, with over 80 percent of its annual sales in North
America, Valspar is nicely leveraged to be an early-cycle play on
the eventual US-led global economic recovery."

Lower interest rates also provide a direct benefit to Valspar as
around 90 percent of its $1 billion in total debt is comprised of
variable-rate instruments, Mr. Gerdeman points out. Each 50 basis
point reduction in interest rates translates into an incremental 9
cents per share of pretax EPS for Valspar, he says. Mr. Gerdeman
rates Valspar a "strong buy."

Along with prospects for significantly lower raw material costs,
investors are also playing the economic recovery. While buying
chemical stocks ahead of the recovery makes sense, it is easier
said than done.

"Historically, you want to buy chemical stocks, especially the
demand-sensitive names, six to nine months ahead of the economic
recovery," says JPMorgan's Mr. Carson. "The problem is that over
the last 12 months, the S&P Chemicals Index has prematurely
forecasted the economic recovery (with 15 percent plus gains) four
times already before this latest rally."

"Chemical stock buying amounts to mind reading, especially this
year," says Argus Research analyst David Kerans. "Periodically,
analysts tell clients to buy chemical stocks two to three quarters
before an economic recovery, but what they're really saying is to
buy the stocks before everyone else buys them because nobody knows
when two to three quarters before the recovery is."

For investors playing the economic cycle, it pays to focus on
the demand-sensitive companies such as DuPont, PPG Industries,
Solutia and Rohm and Haas, rather than capacity-driven companies
such as Dow and Lyondell, according to JPMorgan's Mr. Carson.

Looking back on how the chemicals group performed coming out of
the last recession in 1990 to 1991, "the S&P Chemicals Index
outperformed the overall market, but it was all in the
demand-sensitive names because there were massive increases in
ethylene capacity, just as there are now," he says.

Within the demand-sensitive chemical companies, Mr. Carson
prefers DuPont. "The stock has gone up but we think there is more
to go. They've got the strongest credit rating in the industry and
an aggressive stock buyback program," he says. "Their earnings have
been compressed because they overbuilt inventories earlier in the
year, but as they work through that, I think you'll see a quicker
snapback in earnings at DuPont than at Dow."

Despite positive macro factors such as falling energy prices and
lower interest rates, many on Wall Street are somewhat skeptical of
this latest rally. Argus Research's Mr. Kerans is telling investors
not to get caught up in this rally. "I wouldn't get too excited
because forecasting the demand side is very flimsy."

"It's hard to know when a rally stops, but I suspect it's
getting towards the end right here on a short-term basis," says ABN
Amro's Mr. Begleiter. "Things are looking pretty frothy with the
specialty chemicals group trading at around 18.5x estimated 2002
earnings and 8.5x EV/EBITDA ."

"Most chemical stocks are pretty much ahead of themselves," says
JPMorgan's Mr. Carson. "Next year looks very difficult from an
ethylene standpoint in terms of the supply/demand balance for
US-based producers, so I think we're going to see some retracement,
particularly in the ethylene based names."

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